Financial Management: Theory & Practice
16th Edition
ISBN: 9781337909730
Author: Brigham
Publisher: Cengage
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Chapter 25, Problem 8MC
You have been hired at the investment firm of Bowers & Noon. One of its clients doesn’t understand the value of diversification or why stocks with the biggest standard deviations don’t always have the highest expected returns. Your assignment is to address the client’s concerns by showing the client how to answer the following questions:
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In a seminal article on portfolio theory, Markowitz (1952) illustrated that investors are not compensated for taking on firm specific or idiosyncratic risk; however, they are compensated for taking market or systemic risk. Use your understanding of the Capital Asset Pricing Model (CAPM), statistical concepts such as standard deviation and variance, and our ideas about market efficiency and indicate whether you believe that this is a good theory. Include at least two citations that support your response.
Chapter 25 Solutions
Financial Management: Theory & Practice
Ch. 25 - Define the following terms, using graphs or...Ch. 25 - Prob. 2QCh. 25 - The standard deviation of stock returns for Stock...Ch. 25 - Prob. 2PCh. 25 - Stock A has an expected return of 12% and a...Ch. 25 - Prob. 4PCh. 25 - Prob. 7SPCh. 25 - Prob. 1MCCh. 25 - Prob. 2MCCh. 25 - Prob. 3MC
Ch. 25 - You have been hired at the investment firm of...Ch. 25 - You have been hired at the investment firm of...Ch. 25 - Prob. 6MCCh. 25 - You have been hired at the investment firm of...Ch. 25 - You have been hired at the investment firm of...Ch. 25 - Prob. 9MCCh. 25 - You have been hired at the investment firm of...Ch. 25 - Prob. 11MC
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- You have been hired at the investment firm of Bowers & Noon. One of its clients doesn’t understand the value of diversification or why stocks with the biggest standard deviations don’t always have the highest expected returns. Your assignment is to address the client’s concerns by showing the client how to answer the following questions: Construct a plausible graph that shows risk (as measured by portfolio standard deviation) on the x-axis and expected rate of return on the y-axis. Now add an illustrative feasible (or attainable) set of portfolios and show what portion of the feasible set is efficient. What makes a particular portfolio efficient? Don’t worry about specific values when constructing the graph—merely illustrate how things look with “reasonable” data.arrow_forwardYou have been hired at the investment firm of Bowers & Noon. One of its clients doesn’t understand the value of diversification or why stocks with the biggest standard deviations don’t always have the highest expected returns. Your assignment is to address the client’s concerns by showing the client how to answer the following questions: What are two potential tests that can be conducted to verify the CAPM? What are the results of such tests? What is Roll’s critique of CAPM tests?arrow_forwardYou have been hired at the investment firm of Bowers & Noon. One of its clients doesn’t understand the value of diversification or why stocks with the biggest standard deviations don’t always have the highest expected returns. Your assignment is to address the client’s concerns by showing the client how to answer the following questions: Write out the equation for the Capital Market Line (CML), and draw it on the graph. Interpret the plotted CML. Now add a set of indifference curves and illustrate how an investor’s optimal portfolio is some combination of the risky portfolio and the risk-free asset. What is the composition of the risky portfolio?arrow_forward
- You have been hired at the investment firm of Bowers Noon. One of its clients doesnt understand the value of diversification or why stocks with the biggest standard deviations dont always have the highest expected returns. Your assignment is to address the clients concerns by showing the client how to answer the following questions: Add a set of indifference curves to the graph created for part b. What do these curves represent? What is the optimal portfolio for this investor? Add a second set of indifference curves that leads to the selection of a different optimal portfolio. Why do the two investors choose different portfolios?arrow_forwardYou have been hired at the investment firm of Bowers Noon. One of its clients doesnt understand the value of diversification or why stocks with the biggest standard deviations dont always have the highest expected returns. Your assignment is to address the clients concerns by showing the client how to answer the following questions: e. Add a set of indifference curves to the graph created for part b. What do these curves represent? What is the optimal portfolio for this investor? Add a second set of indifference curves that leads to the selection of a different optimal portfolio. Why do the two investors choose different portfolios?arrow_forwardYou have been hired at the investment firm of Bowers & Noon. One of its clients doesn’t understand the value of diversification or why stocks with the biggest standard deviations don’t always have the highest expected returns. Your assignment is to address the client’s concerns by showing the client how to answer the following questions: Suppose a risk-free asset has an expected return of 5%. By definition, its standard deviation is zero, and its correlation with any other asset is also zero. Using only Asset A and the risk-free asset, plot the attainable portfolios.arrow_forward
- You have been hired at the investment firm of Bowers & Noon. One of its clients doesn’t understand the value of diversification or why stocks with the biggest standard deviations don’t always have the highest expected returns. Your assignment is to address the client’s concerns by showing the client how to answer the following questions: Plot the attainable portfolios for a correlation of 0.35. Now plot the attainable portfolios for correlations of +1.0 and −1.0.arrow_forwardArbitrage is the idea that one can (select the best answer): Group of answer choices Buy and Sell different assets or packages of assets at different prices such you can earn a riskless profit without investing any capital. Earn rates of return greater than the average for the market by successfully “picking” stocks. Earn abnormal returns above what CAPM would predict for a particular security.arrow_forwardYou are concerned about one of the assets in your fully diversified portfolio. You just have an uneasy feeling about the CFO, Ian Malcolm, of that particular firm. You do believe, however that the firm makes a good product and that it is appropriately priced by the market. Should you be concerned about the effect on your portfolio if Malcolm embezzles a portion of the firm’s cash? Discuss in light of your readings on diversification of assets in a portfolio.arrow_forward
- Which of the following statements is CORRECT? a. The SML shows the relationship between companies' required returns and their diversifiable risks. The slope and intercept of this line cannot be influenced by a firm's managers, but the position of the company on the line can be influenced by its managers. b. Suppose you plotted the returns of a given stock against those of the market, and you found that the slope of the regression line was negative. The CAPM would indicate that the required rate of return on the stock should be less than the risk-free rate for a well-diversified investor, assuming investors expect the observed relationship to continue on into the future. c. If investors become less risk averse, the slope of the Security Market Line will increase. d. If a company increases its use of debt, this is likely to cause the slope of its SML to increase, indicating a higher required return on the stock. e. The slope of the SML is determined by the value of beta.arrow_forwardFrom the sentences below, choose the one that DOES NOT fit in the concept of diversification. * An investor should investment her/his money in different types of securites because by doing so she/he will be able to create a compensation effect in which the less good performance of some investments can be compensated by the good performance of other investments. A portfolio constructed of different kinds of investments will, on average, have higher returns and a lower risk than any individual investment found within the portfolio. A very well diversified portfolio should be composed by different types of securities, from different sectors and from different geographical locations. Do not put all your eggs in one basket. In order to have the maximum return, an investor should invest all her/his money in the top 5 best stocks of the market.arrow_forwardWhich of the following statements is MOST correct concerning diversification and risk? Select one:Proper diversification generally results in the elimination of riskOnly wealthy investors can diversify their portfolios because a portfolio must contain at least 50 stocks to gain the benefits of diversification.Risk-averse investors often choose companies from different industries for their portfolios because the correlation of returns is less than if all the companies came from the same industry.Risk-averse investors often select portfolios that include only companies from the same industry group because the familiarity reduces the risk.arrow_forward
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